Lecture 7: Valuation of Stocks and Bonds

Overview

• Combines Chapters 8 and 9 from the textbook.
• Focus on valuation principles of securities: stocks and bonds.
• Skipping Chapter 7 to directly address valuation.

Importance of Valuation

• Understanding the required rate of return (R) for investors.
• R is related to risk for investors like stockholders and bondholders.
• Companies often use both debt (bonds) and equity (stocks).
• Weighted Average Cost of Capital (WACC): combines returns required by stockholders (RS) and bondholders (RB).

Investors' Perspective

• Stockholders: Concerned with their required return (RS).
• Bondholders: Concerned with their required return (RB/ RD).
• Understanding what investors want helps in valuing stocks and bonds.

Bonds

Key Parameters

• Bond: Legal agreement between borrower and lender.
• Par Value/ Face Value: Fixed amount received at maturity, e.g., $1,000.
• Coupon Payment: Regular interest payments, typically semi-annual.
• Coupon Rate: Fixed ratio of coupon payment to face value.
• Maturity Date & Maturity: Fixed end date and remaining years to maturity.
• Yield to Maturity (YTM): Required market interest rate, fluctuates with market conditions.

Bond Pricing

• Price is the present value of future cash flows (coupon payments and face value).
• Price adjusts to ensure yield to maturity is consistent with market conditions.
• Formula involves present value of annuity (coupon payments) and single amount (face value).

Relationship Between YTM and Bond Price

• When YTM > Coupon Rate: Bond price < Face Value (Discount Bond).
• When YTM < Coupon Rate: Bond price > Face Value (Premium Bond).
• When YTM = Coupon Rate: Bond price = Face Value (Par Bond).

Types of Bonds

Pure Discount Bonds

• No coupon payments, priced below face value.
• Example: Treasury bills (short-term).

Level Coupon Bonds

• Regular coupon payments, typically semi-annual.
• Pricing involves present value of annuity and face value.

Excel Functions for Bond Pricing

• Price Function: Calculates bond price using parameters like settlement date, maturity date, rate, yield, redemption, frequency, and basis.
• Example illustrated with a bond having specified coupon rate, maturity, and yield to maturity.

Conclusion

• Bond pricing reflects market conditions through adjustments in bond price.
• Understanding bond pricing involves recognizing the relationship between coupon rate, yield to maturity, and bond price.
• Excel tools can simplify bond pricing calculations.